Why Momentum Funds Don't Have Any

Get mutual fund and stock information from our analyst team delivered to your e-mail inbox every Tuesday. Sign up for our free Investment Insights e-newsletter.

Recently my colleagues at Morningstar held a meeting titled "Is Momentum Investing Dead?"

We're not the only ones asking that question. After all, the practice hasn't really worked much since 1999. A momentum fund is one whose manager invests in companies with fast-rising earnings, surging stock prices, or both in the hopes that all the good news about the stocks is not fully reflected in their prices. Every momentum fund applies the strategy slightly differently, but the basic idea is the same, and they often move in lock step with one another.

The most-tested idea is that stocks that have outperformed over the prior 12 months minus the most recent month are likely to continue to outperform. It sounds strange because we are taught to buy low and sell high, not buy high and sell higher. However, it has worked in the past, and many attribute that success to behavioral-finance concepts that say investors tend not to fully appreciate the degree of change because it's human nature to base your view on past experience and only gradually adjust. For example, when Apple introduced the iPhone, most investors thought it was a nice product extension of the iPod--more of a cherry on top than the category killer it became. Even after the first couple of quarters reflecting sales of the device, you'd have done well to buy the stock. Other angles on momentum focus on companies beating quarterly estimates or use extensive visits and phone calls to get a bead on the next quarter.

Sure, most momentum funds enjoyed a couple of moments in the past decade but not enough to make long-term investors any money. Check out some 10-year performance figures (through Nov. 20) for some prominent momentum funds: Turner Midcap Growth TMGFX: negative 0.3% annualized; Brandywine BRWIX: negative 0.6% annualized; and American Century Vista TWCVX: 1.3% annualized. And it wasn't just individual investors who lost their taste for momentum. Vanguard fired Turner from Vanguard Growth Equity VGEQX, thus leaving it without any momentum investors in the stable.PAGEBREAK

Momentum managers can and do argue that this is a cyclical downturn that will reverse course at some point. Momentum investing enjoyed blowout returns in the late '90s, but that meant momentum stocks had crazy valuations that set momentum funds up for a decade in quicksand as valuations returned to more realistic levels.

The contrarian in me sees those returns and discussions of the death of momentum as an invitation to dive in. History is full of magazine covers proclaiming the death of value or the death of equities at almost precisely the bottom.

However, it's pretty easy to create a program to follow a momentum strategy, and information flows so quickly today that it might be more difficult for a momentum investor to enjoy sustained success.

If momentum is a commodity, then I don't want to pay a 1.3% expense ratio for it. And I don't have to. Rather than figure out a new wrinkle to get ahead of the competition, AQR launched three momentum funds, AQR Momentum AMOMX, AQR Small Cap Momentum ASMOX, and AQR International Momentum AIMOX, which use the classic 12-month price movement minus the last month and charge low fees that place them somewhere between active management and index funds. AQR Momentum charges 0.49%, and the other two charge 0.65%. Alternatively, you could buy one of myriad growth-style index funds available in exchange-traded fund and open-end form for 20 or 30 basis points. They aren't pure momentum, but a decent chunk of each portfolio is.

It could be that the way to go is to plug a small amount of your equity portfolio into the AQR momentum funds or some growth indexes so that you'll have some exposure when momentum finally gets around to producing an extended rally. Then for the rest of your portfolio you can hire some good active managers whose fundamental approaches and long-term focus do give them a competitive advantage.